11 Jan 2016
The Big Short – Not a Canadian Story
The Big Short – An American film about American finance.
Many Canadians, particularly those in Vancouver and Toronto where real estate is spoken of like a sport, will gravitate to the film The Big Short over the coming weeks. It is an adaptation of an excellent book written in 2010 by Michael Lewis. As a Canadian Mortgage Broker who read the book when it came out to better understand the differences between the two countries’ mortgage markets, I was into a theatre within the first few days of its release.
Ryan Gosling is the only significant Canadian content in this film.
This is an American tale about an American debacle that takes place due to American finance policies. A tale, a debacle, and policies vastly different from anything we have happening in Canada. As with most things Canadian, our finance system is in fact far more conservative and quite sedate. It is as solidly built, resilient, and popular as Mr. Gosling himself.
Five key differences between the US and Canadian housing markets
In the USA in 2006 ‘subprime’ mortgages accounted for more than one in three new mortgage applications. Over half required little to no documentation of income at all, and little to no down payment. In the movie there is a case, likely not far from reality, of a property financed in the name of a man’s dog. A system so lax that even your pet could qualify for a mortgage.
In Canada, even in 2006, subprime loans accounted for less than 1 in 20 applications, still fewer today. Even in cases of limited documentation, the Canadian system typically required 35% down payment. Equity = security.
The US system had Mortgage Brokers packaging up loans with little to no oversight or review on a Friday, and selling them the following Monday to an investor on Wall Street who was in turn re-selling the debt to yet another investor in another country. All the while, credit rating agencies focused on maintaining their initial (heavily biased) ratings of mortgage bonds, even as the mortgages inside the bonds were sliding into default, because if they did not maintain the ratings then ‘some other ratings agency’ down the block would get paid to assign a stable rating. It was (and remains) a system designed to offload risk as if all the players involved are playing a protracted game of musical chairs. They all know the music might stop at some point, but are willfully blind to it.
And hey, last time the music stopped the people turning a blind eye got little more than a slap on the wrist, and most kept their jobs and were paid their annual bonuses anyways.
In Canada, the lender, often a Credit Union or Chartered Bank, has rigorous approval standards that leave most applicants’ heads spinning, with some wondering if a hair sample will also be required. Mortgage Brokers in Canada are licensed and regulated. More important still, few Canadian mortgage applicants ever pay any kind of fees or higher-than-market rates. Nor have I had any clients simply sign documents without spending the time to understand exactly what they are signing on for.
The US system created A.R.M.’s, an unbelievably good deal on paper… at first. Recall the subprime mortgages from point 1 above. Well, about 90% of those mortgages (the ones written for people with no income) were written as A.R.M.’s.
Mr. & Mrs. American, please sign here for your A.R.M.
What’s an A.R.M.?
This was a question that millions seemed either not to ask, or did not dwell long on the answer to.
A.R.M. = Adjustable Rate Mortgage:
The pitch in 2004: “Today and today only, we can give you a 1.00% rate with interest-only payments for the first three years (Yes it gets better still: interest-only payments). That’s right, your payments will be just $415.80 per month on a $500,000 mortgage. In three years the interest rate will reset (keyword there: reset) to 4% over a 30-year amortization, but no need to worry about that as we will just refinance you at that time or flip out of the house since it will be worth so much more; just look how much it has risen in price since I started speaking a few minutes ago…”
“What’s that? How much is the payment at 4%? Why, you’re the first one to ask me that in months. I am not even sure. Let me figure it out ”(Leaves to find office manager, who in turn finds a guy that was in the business a few years earlier when math was still important. Returns.) – “It would be $2,377.59 per month. Yes, that is much higher, but hey it’s only $415.80 for now, and three years is an awful long ways away”.
In Canada it is rare to see a ‘teaser rate’ mortgage as we call them, as the optics are not great around such products since 2007. However, when you do see a mortgage product such as this in Canada, the qualifying rate used is not the artificially low teaser rate as with the US system, it is the higher (inevitable) interest rate that is used to ensure that the borrowers will have stability.
In Canada we have variable-rate mortgages which are significantly different products and again use a qualifying rate much higher than the effective rate. At the time of this writing a variable rate mortgage is at a net rate of 2.20%, but the qualifying rate used is 4.64%. In other words, the Canadian system goes the opposite path of the US system. We ensure an applicant is well overqualified for the mortgage they are applying for.
Many US residential home builders are publicly traded companies, and as another by-product of the bubbly finance system at the time, vast sums of money were thrown at them to build, build, build, and build. In 2004 it was estimated that 40% of US real estate purchases were investment or vacation homes.
In 2006 there were already vast numbers of partially constructed homes that were no longer selling, there were no buyers for them. The overbuilding was significant, and as the economy slowed it was one more layer on a rapidly rolling snowball that became an avalanche.
Meanwhile in Canada… more than 90% of real estate purchases are for owner-occupied properties, with less than 4% of mortgages being written for investment properties. Supply in most markets remains tight. Markets like the city of Vancouver, have seen the last single-family home site created. In fact, single-family homes are dwindling in many urban centres as consolidations occur to create new multi-family sites. With geographical constraints such as mountains, coastlines, borders and agricultural lands among the myriad of limitations to growth (a.k.a. ‘sprawl’), the supply side of the equation in cities like Toronto and Vancouver will not be easily remedied anytime soon.
Mortgages in many states are ‘non-recourse’ loans, meaning that the lender cannot go after the borrower for any monies owed over and above the final sale price of the asset pledged. In states such as California and Arizona, this led to many ‘strategic defaults’ by borrowers. Essentially these were an exit plan for home owners with otherwise good credit and stable incomes who found themselves saddled with a mortgage balance more than double the market value of the home. Looking at how long it would take to pay the debt, and whether the home would ever recover its value, many people chose to throw the keys to their homes — or at least their second, third and fourth homes — on the desk of the bank and walk away.
This played a role in foreclosures rising to 14.4% of all mortgages in the USA by September 2009.
Meanwhile in Canada, all mortgages are full recourse, which means that the lender can (and will) chase the homeowner to the ends of the earth for repayment of any loss, garnisheeing wages if need be to collect monies owed.
In 2009 Canada also hit a record high foreclosure level… of 0.41%. This is just slightly above the twenty year average.
As the movie ends it is a scene of massive government bailouts, another thing that no Canadian bank required through that period of time (in fact Canadian Banks were the only lenders in the G7 that did NOT require Government assistance). It was also a scene, unchanged to this day, of little fault being found with those who built a system doomed to failure. There were no jail sentences for those involved in perpetrating what became a massive global economic meltdown. It was as if this were something that just happened on its own. A force of nature.
In the USA there was clear evidence of fraud at all levels in a broken system that rewarded multiple layers and players to look the other way and ‘go along to get along’.
In Canada we are conservative by nature. As a Mortgage Broker myself, I am on the front lines dealing daily with fiscally prudent clients who opt to borrow, in most cases, significantly less than they (painstakingly) qualify for. I then get on the phone to fiscally prudent underwriters at fiscally prudent lenders and work through a hurricane of paperwork for an approval.
Also, I have not met a Canadian Mortgage Broker with a lounge sized fully stocked bar in their offices serving Caesars at noon as if work is just one big party (see the movie). Alas, we are a far more boring bunch here with actual work in our workdays.
As much as many would like to draw comparisons to the Canadian and USA real estate markets, there are few commonalities to be found that are any more logical than the following theory:
‘Ryan Gosling starred in a film about the US mortgage meltdown, Ryan Gosling is Canadian, Ryan Gosling is mortgage meltdown, mortgage meltdown is Canadian’…um ya – Illuminati confirmed!
Great flick though, an excellent adaptation of a great authors work.